Spooky Friday Morning

I'm no longer apologizing for being skeptical into the rallies.

Yesterday was tough as I made a series of bearish calls in the afternoon as the Dow hit 9,200 which were ingenious at 3:45 as the Dow broke 9,050 but had us very nervous as the Dow went right back to 9,200 just 10 minutes later.  Still, we held fast as I have my overwhelming concern that the weekend will arrive as scheduled this afternoon and we have a tough data day today and, most importantly – we STILL have not made our levels.  A buy program or a sell program can only move the market so far until it runs into real resistance and that's what we take full advantage of with our intra-day trading.

David Fry summed up yesterday's action perfectly: "Yep, it was that kind of day. Was there any good news to account for an up day? Absolutely nothing, unless you think the GDP data falling a little less than expected was something to place bets on.  Nope, the market is just oversold and this is the end-of-month prop job mutual funds and a few others need…  So desperate are bullish tape painters they ignored San Francisco Fed President Janet Yellen’s statement that “…recent economic data is deeply worrisome and the economy is likely to contract significantly in the fourth quarter.” Sure, that’s really bullish!"  I also strongly recommend linking to David's column as he has a great series of charts that give a nice overview of where we are at the moment.

We have some very scary Personal Income and Spending data hitting us at 8:30 followed by the downwardly creepy Chicago PMI at 9:45 and the gloomy Michigan Consumer Sentiment for October, which may be revised below 50, more than 10% down from September.  Also sending chills down my spine was a WSJ story on the conference of the Turnaround Management Association, who are expecting a banner year in '09.  "We're all salivating. Wait. Don't say that," said one bankruptcy lawyer. "This is clearly the most devastating economic situation I've seen in my 40 years. I would say there is some distress even among the distressed-debt community," said Henry Miller, co-founder of the turnaround firm Miller Buckfire. Revenue is up by about one-third this year, he said. "Many of the patients are getting to us too late, I fear."  I like that he thinks of himself as a doctor performing emergency surgery…

"I am like an air-traffic controller with five planes trying to land at once. And they are all on fire," said Gregory Segall, managing partner at Versa Capital Management Inc., a $1 billion distressed-investment fund in Philadelphia. "Our greatest competition to do a deal is liquidation, getting the deal done before the bank or lender pulls the plug on a company," he said.  Through the first nine months of 2008, Standard & Poor's Corp. said that 66 companies have defaulted on $218 billion in rated corporate debt. That compares with 53 companies defaulting on $11 billion in rated debt for all of 2006 and 2007.  Mr. Miller and others estimate there is $2.3 trillion in leveraged and high-yield loans right now, with about one-quarter of that rated CCC or lower — a subinvestment grade rating that indicates a higher likelihood of default. Much of it comes dues in 2009 and 2010.  BOO!

Bill Gross put out a predictably scary newsletter this morning calling the economic collapse: "a nuclear implosion – destructive fusion not controllable fission."  The article is a good read and Bill does say, however, that "perhaps over the next few weeks or months, when deleveraging of the private sector is met by the leveraging up of the government sectors: the TARP, CPFF, and MMIFF will inject over a trillion dollars of liquidity into the system over a short period of time. At that point, our nuclear atom will begin to stabilize and it should be safer to move a little distance back out toward the perimeter where yields and potential returns are very attractive."  Obviously, Mr. Gross is a student of my Stock Market Physics class and agrees with my underlying bullish premise – $1Tn is a LOT of money and it has to move the markets at some point.

Speaking of Physics, we have been applying some fundamental market laws to trades this week that are based on the premise that there IS a limit to how low a stock can go and we've been taking advantage of the outrageous premiums that are reflected in the options contracts to make interesting plays.  One I saw yesterday during member chat is a great example of simple option plays you can make that can generate a significant return – even in these terrible markets.  We looked at LVS, which closed at $10.38 and the play is to buy the stock, sell the Nov $10 call for $2.58 (prices at close) and also sell the Nov $10 puts for $2.20.  As you are collecting $4.78 in credits, the net cost of entry is $5.60. 

There are two possible outcomes on Nov 21st (option expiration day):  If LVS closes above $10, you will be called away from your position at $10, a 78% gain off your $5.60 entry.  You will not owe your put holder any money as the stock is over the $10 strike price.  If the stock finishes below $10, you will not owe your caller any money but an additional round of LVS shares will be put to you at $10.  That $10 plus your $5.60 net entry on the first round will put you into LVS for an average cost of $7.80, which is a 25% discount off the current price.  So the point to this trade is – as long as you feel you wouln't mind owning LVS for $7.80 long term – this is not a scary play at all!  These are the kind of trades you SHOULD be making in these markets, taking advantage of the fears of others that is causing implied volatility to skyrocket.

Options are a way to mitigate fear in a scary market and those of you who own stocks are doing yourself a grave disservice by ignoring the very profitable strategies that can be employed by buying protective puts (especially against dividend paying stocks) or selling calls to others to generate a steady monthly income.  Why sit on your $19.35 share of GE hoping it will go up when someone is willing to pay you $2.20 to buy your stock from you for $19 on Dec 19th?  The net $1.85 call away is 9.5% of your stock price in 50 days – far outpacing the 6.5% annual dividend.  If you intend to hold a stock through thick and thin, then what's so terrible about lowering your basis to $17.15?  If you do get called away, you can always buy more…

Warren Buffett rightly said "Be greedy when others are fearful" and that's the underlying philosophy to the trades we've been going after for the past few weeks, these wild market swings are great entry opportunities for long and short plays but we prefer to take advantage of premiums by being mainly a seller, not a buyer of options.  Another great trick in a volatile market is, rather than buying a stock you think is "cheap," simply selling the put.  Selling a put gives someone the right to force you to buy a stock for a certain price on a certain date so, if you want to by GS (along with Mr. Buffett) on yesterday's dip to $89, you can give yourself an automatic discount by selling the November $85 puts for $8.  You collect $8 up front and, if the stock is put to you at $85 by 11/21, your net entry is just $77, 13% less than the current price.  If GS continues higher, you will NOT end up with the stock (that is the "downside," the lack of upside) but you will keep the $8 as the obligation expires – not a bad profit for 2 weeks without ever actually taking ownership of the stock. 

There are, of course, more complex strategies that can benefit you on both ends but it amazes me how many people have money tied up in virtual portfolios and just let them lay there, not even attempting to unlock the revenue generating potential that can be realized through option selling.  It's a strategy well worth checking out, especially for many of you who depend on getting a monthly income from dividends and are seeing your virtual portfolio values shrink and feel you may need to sell stocks at these lows to make ends meet – that's why I'm discussing this now as I've spoken to some new members in this situation and it seems to be all too common this month and, from my perspective, there is always an option…

Japan may be out of options as they cut their 0.5% rate to 0.3%, which is a 40% cut but investors didn't see it that way and the Nikkei sold off 5% on the button, back down to 8,576, which is 53% off the 2007 highs.  The Hang Seng pegged the 2.5% rule on the nose as well while Shanghai fell 2% to close the week sadly at 175, over 70% off the high of 588.  The Baltic Dry Index fell 5% as well as commodities continue their global collapse – which is great for us as we stayed short on oil into that BS rally.  In pre-market trading, oil dipped to $63 a barrel and Brent crude was down to $60 and threatens to break that mark if US equities don't save us today.  News that should not be ignored out of India is a series of 13 coordinated bombings that killed 61 people, injuring 300 others in an escalation of separatist violence. 

Europe is mixed ahead of the US open with not much news over there.  There is still the anticipation of an ECB cut next week and there will be heavy disappointment if it doesn't come through.  US indexes have recovered from some disappointing futures and look to open flat as well but unless we go flying through the levels we laid out in yesterday's post, we're certainly going to remain well covered into the weekend.  Consumer spending was down 0.3%, about what was expected and the dollar is gathering strength again so it should be a technical trading day overall. 

If nothing blows up over the weekend and we don't have any countries or major corporations entering bankruptcy, we may be able to make some progress next week but, until we get the majority of our indexes over the 40% mark – let's continue to proceed with caution and remain well hedged.